Kellogg EMP 62 Corporate Finance Capital Structure 1 Today s Agenda Introduce the effect of debt on firm value in a basic model Consider the effect of taxes on capital structure, firm valuation, and the cost of capital Understand the role of financial distress and bond covenants in determining financial structure Appreciate the trade-off approach to capital structure 2 1
Outline of Topics Capital Structure: the basics Taxes Costs of Financial Distress Bond Covenants 3 Capital Structure is the way a firm's assets are divided between different claimants. Central question: Is there an optimal capital structure? that is, is there a set of securities that minimizes the firm's cost of capital (and hence maximizes shareholder value)? 4 2
Starting with a basic structure, we first ask How does leverage (debt) affect valuation? 5 Example 1: Firms A, B, and C are identical in every way except their capital structures. The face values of their debt are 15, 50, and 100, respectively. The following table gives their liabilities in each of 5 possible states: Asset Value Prob D(A) E(A) D(B) E(B) D(C) E(C) 25.2 15 10 25 0 25 0 50.2 15 35 50 0 50 0 75.2 15 60 50 25 75 0 100.2 15 85 50 50 100 0 125.2 15 110 50 75 100 25 Which firm is the most likely to go bankrupt? Which firm has the riskiest debt? Which firm is the most valuable? 6 3
Example: A firm s assets pay off $1100 with 50% probability $3100 with 50% probability The risk-free rate is 5% What would be today s value of the firm s assets if they were risk free? How does the risk associated with the assets change your answer? 7 Suppose the current price of the firm s assets is $1800. What is the cost of capital of this firm? $1800 = (.5 1100 +.5 3100)/(1+r) solving for (1+r) = 1.167, or r = 16.7% Suppose we promise to give $525 to someone else (regardless of which payoff occurs) What is today s value of that claim? 525/1.05 = $500 Now... What happens to the value of the firm? What happens to the cost of capital? 8 4
Capital Structure Affects the Character of the Equity Claim Even when equity-holders own the entire firm the value of their claim is less the greater the amount of debt in a firm s capital structure. Why? Equity holders must pay part of the assets cash flows to debt holders. Since debt is senior to equity, its claim must be paid first, making the equity riskier. 9 These examples show that leverage changes the payoffs to equity (and therefore the value and required return of equity), but leverage does not by itself change the value of the firm. In this basic structure, there is no connection between the firm s assets and liabilities. 10 5
Capital Structure with Corporate Taxes How would you value a firm with no debt? Consider the cash flow to equity cash flow to equity = EBIT(1-τ c ), in perpetuity where EBIT = earnings before interest and taxes The present value of this stream of cash flows depends on the required return on the assets of the firm if owned as an all equity firm. Call this r Eu, the required rate of return on unlevered firm or unlevered equity. V u = EBIT(1-τ c )/r Eu 11 Now add leverage to the firm: Consider the cash flow to all claimholders of the levered firm. The debt has face value F and coupon rate, R D ; coupon payments are tax deductible at the corporate level. Cash flow to equity = EBIT - R D F - τ c (EBIT - R D F) Cash flow to debt = R D F Summing gives the total cash flow to all holders: EBIT -R D F - τ c EBIT + τ c R D F+ R D F = EBIT(1-τ c ) + τ c R D F Note that the cash flows have gone up as a result of the leverage! 12 6
Using the cash flows = EBIT(1-τ c ) + τ c R D F, now calculate the value of the firm: The first term is the same as the cash flow to equity of the unlevered firm, so we know its value from above: EBIT(1-τ c )/r Eu = V u. The second term τ c R D F is the tax shield on the interest payment of the debt. If r D is the opportunity cost of capital for this debt security, then the value in perpetuity of this term is τ c R D F/r D = τ c D (The last equality is true because the term R D F/r D is equal to the market value of a perpetuity of interest payments of R D F.) 13 Summing these terms, we find the value of the levered firm V L = V U + τ c D (with no leverage-related costs) Note that the value of the firm is increasing with leverage, due to the favorable tax treatment of debt. The next example gives a flavor of the magnitude of the tax benefit of debt financing. 14 7
Example: Calculating the Tax Benefits of Debt Your company is considering opening a new production facility. If you go ahead with this project, the company will be able to take on an additional $5 million in debt. τ c =.35 a) If the interest rate on the new debt is 10%, what are the annual interest payments? b) What are the annual tax savings? c) If the new facility lasts indefinitely so that the debt is perpetual, what is the present value of the tax savings? 15 This example accounts for corporate taxes, but what about personal taxes? But wait! We re talking about corporate valuation, so why are personal taxes relevant? Remember, corporations are owned by shareholders who eventually pay personal taxes Equivalently, firms raise financing by issuing securities to debt- and equity-holders the cost of capital (required return) demanded by the debt and equity holders depends on all the taxes they face 16 8
Two types of personal taxes are relevant here: t pd = marginal personal tax rate on debt income t pe = marginal personal tax rate on equity income Income on debt securities is taxed as ordinary income, while income on equity is a mixture of ordinary and capital gains (depending on the firm s dividend policy and individuals portfolio strategies). 17 In order to assess the effect of taxes on the cost of capital, we need to ask: How much of each pre-tax dollar of corporate income does an investor receive? This depends on whether the investor holds the firm s debt or its equity: $1.00 in pre-tax corporate income Debt Security Equity Security $1 after corporate tax (1 - t c ) $1 after corporate tax (1-t pd )$1 after (1- t pe )(1 - t c ) $1 after corporate & personal taxes corporate & personal taxes 18 9
How do these personal taxes affect The value of the firm? The firm s cost of capital? 19 Personal taxation of debt income: Most of debt income (interest, amortization of original issue discount, etc.) is ordinary income, hence is taxed at the marginal tax rate of the holder. The relevant tax rate, τ pd, is the marginal rate of the bondholder setting prices in the debt market. The investor who is indifferent, at the margin, between buying and not buying. This is an important issue because τ pd is not small. 20 10
Personal taxation of equity income: The effective tax on equity,τ pe, is harder to estimate. Equity income comes in the form of dividends, realized capital gains (losses) and unrealized capital gains (losses). Dividends are now taxed at most 15% (lower for the lowest tax brackets). (Dividends are 70% excluded from income to corporate holders.) 21 Much of equity income is in the form of capital gains. Capital gains are not taxed until they are realized. Realized capital gains are taxed at a lower rate than ordinary income (15% maximum rate). The basis of stocks passed on in one's estate are stepped-up to the current price without tax incidence. Equities, being much more volatile than most debt instruments, offer increased tax reduction opportunities. 22 11
Netting out the effects of corporate and personal taxes: τ pe is usually much less than τ pd. Hence, while debt offers tax advantages at the corporate level (tax deductibility of interest payments), debt is tax-disadvantaged at the personal level. Debt-holders require a larger tax premium than equity-holders, and the corporation must pay this premium. Bottom Line: Personal taxes undo some of the tax benefits of debt at the corporate level. 23 Under the current tax code: A typical value for τ pd would be a high tax bracket for an individual, but unlikely to exceed the corporate tax rate, say τ pd is between 30% and 35%. (Those in higher brackets would hold tax exempt securities.) A typical value for τ pe is debatable, but because of the flexibility of realizing capital gains and greater opportunities to trade to reduce the tax impact of stock portfolios, τ pe is likely at most 15% So, the tax benefit to debt under the current tax code is probably 15% to 21% (somewhat less than the corporate tax rate) What would be the effect of the Congressional initiative to lower the capital gains tax rates to zero? 24 12
III. Capital Structure in Imperfect Markets -Costs of Financial Distress The last few examples we have worked show that capital structure can affect firm value because of the asymmetric tax treatment of debt and equity. Capital structure can also affect firm value if there are costs of financial distress. 25 Costs of Financial Distress The firm s optimal capital structure choice is a trade-off between its own costs of financial distress and the tax benefits of debt. Costs of financial distress (leverage related costs) 26 13
In bankruptcy, a firm cannot meet its debt liabilities. Some argue that bankruptcy costs are small because firms can be liquidated inexpensively Others point to large direct and indirect costs. Direct costs lawyer's fees, administrative fees Indirect costs (effects on productivity) lost sales due to service or continued relationship lost employees credit availability before Chapter 11 business decisions reviewed by trustee in Chapter 11 (pass up NPV > 0 projects) cash demands by suppliers 27 Famous Case: Litigation between Texaco and Pennzoil Pennzoil had agreed to purchase 3/7 of Getty Oil Texaco entered into agreement subsequently to pay a higher price for all of Getty Oil and indemnified Getty's directors against liability 28 14
Not surprisingly, Pennzoil sued. Tried in mid-1985, and a Texas court ruled in favor of Pennzoil and ordered Texaco to pay $12 billion ($10.5 before interest charges) The outcome was ridiculous. $12 billion was the replacement value of all oil Pennzoil could have gotten from Getty, but did not subtract out what they would have to pay Getty to get it (and also ignored discounting!). 29 Texaco fought the settlement through several appeals, but ultimately had to declare bankruptcy in Chapter 11. Finally, the shareholders of Texaco, led by Carl Icahn, settled with Pennzoil for $3 billion Important dates in Pennzoil case The dollar changes are changes in market value (millions of dollars) of the companies from one day before an announcement to five days after the announcement (after subtracting off the expected price change based on the market movement). 30 15
Event Date Texaco Pennzoil Total Original jury finding 11/19/85-1,124 483-731 Judge refuses to overrule 12/10/85-807 -138-946 Supreme court overturns ruling favorable to Texaco 4/6/87-1,257 499-759 Texaco files for bankruptcy 4/12/87-308 -646-954 Total 11/85-10/87-2428 -1307-3735 Total 11/87-12/87 +1,766-622M 868-439M 2625-1110 At least a billion dollars value was destroyed in the process. 31 The existence of bond covenants suggests that bondholders need to protect themselves when a firm is in financial distress What is the purpose of these covenants? Over-investment Example: Suppose that debt value F = 100. Share holders know that the assets are worth $101. They have two choices, pay off debt holders and keep the $1 residual or sell $20 worth of assets and go to Las Vegas. If they go to Vegas, there is a 2/3 chance they will lose the $20; and a 1/3 chance they will return with $30. For simplicity ignore discounting. 32 16
This gamble would affect: Expected Value of the Firm s Assets = 2/3 (-20) + 1/3(10) = -$10.00 Expected Payoff to Stock holders = 2/3(-1) + 1/3(10) = $2.67 Expected Payoff to Bond holders = 2/3(-19) + 1/3(0) = -$12.67 33 Under-investment Example: Suppose that F = 100 and that shareholders know that the assets are worth only $80 (the managers know the firm is bankrupt). A project comes along that costs $5, and will pay off $15 for sure. This is clearly a good project for the firm, but since it does not enhance the value of share holders managers will be indifferent to taking it. If they have another use for the funds (like a risky negative NPV project), they would reject this project. This, too, destroys asset value. 34 17
There are many other strategies to compromise debtholders (to the advantage of equity holders), such as Cashing Out Directors continue declaring dividends after they know the firm s assets will not be sufficiently valuable to meet the future payments promised to bondholders. Bait and Switch If shareholders in a levered firm increase substantially the amount of debt they have outstanding (without making it subordinate to the existing debt), the claim of the existing debt-holders becomes more risky without providing them with compensation for this risk. 35 Thus, an important indirect cost of the possibility of bankruptcy arises because of Conflict of Interest Between Stockholders and Bondholders Managers running the company to maximize current shareholder wealth may sometimes do so at the expense of other claimants (existing bondholders, other employees, etc.) 36 18
These potential conflicts impose costs on equity holders higher interest costs possibility of credit rationing and help explain why start-ups use little debt why firms with stable earnings have relatively more debt 37 Debt Covenants are used to mitigate these costs arising from conflicts between equity and debt-holders Common forms of debt covenants: Me-first rules: often debt covenants will restrict the company from issuing new long term debt with maturity earlier or the same maturity (and equal priority) as the debt issue. Restrictions on: merger and acquisition and divestiture activity; payment of dividends, or payments to shareholders; increases in compensation to executives; financial ratios related to riskiness of debt, such as Debt/Total Capital, Current Ratio, Quick Ratio, Interest Coverage Ratios, Working Capital levels, etc. 38 19
But debt covenants do not completely eliminate the agency costs of conflicts among bondholders and stockholders. We still see event risk bonds, and the existing bondholders of firms that do LBO's or leveraged recapitalizations take large losses. 39 In sum, the tension between tax savings from debt and debt-related costs leads to the tradeoff theory of capital structure: V L = V U + PV(tax shield) - PV(costs of financial distress) 40 20
Key Concepts Without frictions (like taxes), leverage affects the payout to equity, but does not change the value of the firm (asset value). Since debt is paid out of pre-tax profits, corporate taxation favors debt finance. Thus, capital structure affects firm valuation and the cost of financing. Personal taxation affects the required returns to debt and equity. Thus, personal taxes affect the firm s cost of capital and valuation through the value of tax shields. While corporate taxation tends to favor debt finance, costs of financial distress may impose limits on the benefits of leverage. Moreover, conflict of interest between debt- and equity-holders has to be dealt with, for example with bond covenants. 41 Corporate tax rates: Tax rate links http://www.irs.gov/pub/irs-soi/02corate.pdf Effective Federal Tax Rates: http://www.cbo.gov/showdoc.cfm?index=5746&sequence=1&from=0 42 21